Description

LKQ is a compelling long because:

·        LKQ is a high-quality, underlevered and growing business with low cyclicality trading at 12.5x next year’s cash flow

·        LKQ will grow cash flow per share by 10%+ for many years. IRRs appear compelling in any reasonable scenario

·        Near-term earnings expectations are too low

·        Beginning this year, LKQ will repurchase least 6% of outstanding shares annually

LKQ has three reporting segments which can be viewed as largely separate businesses:

North America (54% of EBITDA) – Sells alternative collision auto parts to collision repair shops in North America. After an accident, a car can be repaired with either parts manufactured by the same company who made the vehicle (OEM parts) or new / recycled parts from a third-party (alternative parts). Alternative parts have the advantage of being approximately 25% cheaper than OEM parts while providing identical quality and performance.

LKQ is the leading distributor of alternative automotive collision parts in the US. Alternative parts are either new aftermarket parts (50% of segment sales) or recycled/refurbished parts taken from dismantled vehicles (30% of segment sales). LKQ is the only national player in this market and is at least 20x the size of the next largest competitor. Aftermarket parts are manufactured by third party suppliers mostly in Taiwan. Recycled / refurbished parts are taken from salvaged cars mostly purchased at auction and processed at the company’s nation-wide network of scrap yards.

Approximately 6% of segment revenue is from self-service operations where people go to a junk yard and remove parts themselves and 14% is the sale of scrap metal from what remains of cars purchased for salvage. Metals prices are highly volatile and changes in the price of scrap metal can have a significant impact on quarterly sales and margins.

Over the 8 years prior to 2020 organic growth in North American averaged 4.2%. While there has not been a material deal in this segment since 2010, LKQ will make very small and highly accretive acquisitions every year.

Growth will continue to be in the 2-4% range over-time due to: 1) Growth in miles driven, 2) Price inflation, and 3) Increased penetration of alternative parts. This growth will be somewhat offset by an increasing percentage of crashes which are not repaired (totaled) and impact from new anti-collision technologies.

Europe (35% of EBITDA) – LKQ is the leading distributor of mechanical automotive parts in Europe. Mechanical parts are things like breaks or engine parts used in routine repair work rather than structural parts like doors or fenders that are needed for collision repair. This segment distributes over 900,000 parts from a large number of suppliers in 22 countries. The majority of customers are independent professional repair shops. LKQ is over 2x the size of the next largest distributor in the EU and the only pan-European distributor with #1 market share in every significant country where they operate. Germany is the company’s largest market accounting for 28% of sales, followed by the UK at 27% and Benelux at 13%

Over the 4 years prior to 2020 organic growth in the European segment averaged 3.9%. It appears reasonable to expect 2-3% organic growth over-time from slow market growth and continued modest share gains. This business was built via four large acquisitions from 2011-2018. Similar to the North American segment, economic sensitivity is modest as any decrease in miles driven due to an economic slowdown is offset by fewer purchases of new vehicles. The total market for mechanical parts in Europe is estimated at €78B. The market is highly fragmented with LKQ’s biggest competition coming from “national champions” that hold a #2  position (after LKQ) within a certain country. These national campions are generally private or small parts of larger companies. They include In WM Trost in Germany, Doyen Auto in Belgium and Datacol in Italy among several others. Customers and suppliers are also highly fragmented. This business is somewhat seasonal as cold and severe weather increase the need for repairs. Weather can also be a factor in this segment, but the impact is generally smaller than the North American segment

The market is slowly growing from increases in number of vehicles, miles driven and modest pricing.

The European market appears to be consolidating. Genuine Parts Company (the owner of NAPA in North America) and Autodis (owned by Bain but said to been looking to IPO) have made acquisitions and there have been other small deals as well. The market remains highly fragmented and LKQ has the highest market share by a large margin.

Specialty (11% of EBITDA) –The specialty segment is the number one distributor of RV and specialty automotive parts and accessories to RV dealers, specialty automotive dealers and installers in North America. This segment has over 20,000 customers and stocks 185,000 unique SKUs. Approximately 40% of this segment is RV related with most of the remaining businesses relating to various types of performance or aesthetic automotive modifications.

Over the last 6 years organic growth in the Specialty segment has averaged 4.4% with a modest increase in margins. Some of this growth is due to a strong automotive and RV cycle, so over-time 3-4% growth seems more reasonable. Unlike the other two segments, many of these products relate to discretionary purchases which creates an element of economic sensitivity not present in the other two segments. However, even in a recession segment profits should fall <15%. This segment was built largely from the 2013 acquisition of Keystone Specialty.

LKQ’s Moat

Three observations support our view that LKQ has a strong moat:

1) High and stable market share – LKQ’s North America business is 20x the size of the nearest competitor. In Europe they have the highest share in almost every market where they operate and are more than 2x the size of the next largest competitor. Except for a brief period in 2019 when the company discontinued some business as part of their reorganization, this market share has been stable or growing.

2) High and stable returns on capital – LKQ has consistently produced high teens / low-20s returns on tangible capital for many years.

3) Failed entry by strong competitors – Over the years there have been attempts to compete with LKQ’s North American segment, including attempts by companies with strong positions in other parts of the automotive market. Several years ago, AutoNation attempted to compete in the collision parts business and failed to gain traction before shutting down the segment.

LKQ has a wide moat due to economies of scale. Distribution businesses have a high fixed cost base due to the required logistics and transportation infrastructure. Distributors with high market share can spread these fixed costs over a larger customer base than those with lower share. This not only leads to higher profitability but also allows high market share businesses to provide lower costs, and better service to customers creating a virtuous cycle of higher market share, higher profitability and better customer service /pricing.

For automotive parts, fixed costs are particularly high due to the industry’s unique inventory needs. When a repair shop orders a part, they generally expect to receive it quickly – often in a matter of hours. Given the vast number of different makes and models of cars on the road and the large number of unique parts each of these cars contains, auto parts suppliers must hold a substantial amount of inventory close to customers in order to achieve the needed delivery times.  It would not be profitable to have the required infrastructure / inventory needed to service a particular market and only sell to a small percentage of that market. This creates barriers to entry since new entrants would need to take significant share in order to be profitable and gaining this share would be difficult due to incumbent advantages.

Expectations are Too Low

LKQ’s 2022 earnings expectations appear at least 10% too low. The primary reasons for this are:

1) Share repurchases are not factored in - Management is now focused on returning cash to shareholders. LKQ has been assembled via acquisitions over many years. Current management took over in 2017 and made one final major European acquisition in 2018. Additional large acquisitions are unlikely for at least the next several years, leverage is already far below optimal / target levels, and the company has never paid a dividend. As such, we expect nearly all cash flow to be used for buybacks which means that for the first time LKQ will repurchase a significant portion of its own shares every year.

2) North American margin expectations are too low – Most street models have 2022 North American EBITDA margins estimated at 16.5% -17%. This is likely calculated by taking current margins and subtracting certain non-recurring benefits. However, as LKQ recovers from last year’s unprecedented sales decline incremental margins should be well about trailing margins. Conservatively assuming a 27% incremental margin (well below the segment's mid-40’s gross margin) implies segment margins of about 150bps higher than expectations which drives EBITDA above consensus levels. 

Estimates are likely too low because the market has not fully realized the implications of the strategy shift LKQ undertook in 2019. Whereas prior management prioritized top-line growth and acquisitions, in 2019 the company changed focus to margins and cash flow.

Under previous leadership cash flow and margins underperformed, allowing significant opportunity for improvement. This strategy along with a period of pricing pressure by OEMs lead to years of flat margins despite growing sales. Last year, the company implemented a comprehensive overhaul of the North American segment which increased segment margins by over 300bps and will allow for modest operating leverage (as would normally be expected for a distribution business such as this). The full extent of these improvements will soon become apparent after recent COVID-induced business disruptions are resolved.

Other Sources of Potential Upside

There are four sources of additional upside not factored into our numbers that could cause expectations to prove to be even lower than we think:

1) Growing Diagnostics Business – LKQ is the largest mobile diagnostics provider in the US. While this business is small today, the market is growing at high-single-digit rates and has a long runway for increased penetration. Given LKQ’s relationships with both repair shops and insurance carriers it seems likely the company will capture a significant portion of this market growth.

2) Upside to European Margins – LKQ is just beginning to see results from the multi-year effort to improve European margins called “1 LKQ”. Even though the 1 LKQ rollout is only partially completed, YTD European margins of 10.2% have already hit the stated margin target. Management has been indicating they see longer-term upside to their targets and given the company’s scale in Europe and likely benefit from procurement initiatives, over time segment margins could be higher than we’re underwriting.

3) Continued Share Gains – Over the last year LKQ has gained market share primarily because many small competitors' operations were impacted by market disruptions. On the Q1 earnings call the company noted “we are confident that we are gaining market share from small salvage and aftermarket operators that are typically capital-constrained and facing lower inventory levels due to product availability and cost inflation.” For 2Q21 claims were down 15% vs. 2019 yet sales were down only 9% implying that LKQ is gaining share.

4) Increased Used Car Prices – Skyrocketing used car prices should reduce the total loss percentage in North American and encourage European customers to choose to repair older vehicles.

New Narrative = Potential Rerating?

In 2018 /2019, shortly after the current management took over, LKQ began trading at a lower-than-historical multiple. This downward rating was driven by negative investor perceptions including:

Below average management / Failure to deliver on European margins – In the past LKQ has been viewed as poor operators who do not consistently meet their margin goals and make poor acquisitions. CEO Dominick Zarcone was pejoratively referred to as a “banker”.

Cash flow consumed by acquisitions and working capital – LKQ has historically not returned significant cash to shareholders. 

Slow growth – While LKQ will always show modest top-line growth, operating leverage and buybacks should cause cash flow per share to cash flow per share to grow substantially faster than in the past.

Many investors still hold these negative views. However, as management continues to meet their operational and capital allocation targets, the perception should change. I believe LKQ could eventually be viewed in a similar manner to names like AZO or CHTR where a strong moat, consistent slow top-line growth with some operating leverage and steady buybacks combine to grow value per share over time.

Financial Model and Expected Returns

Our base-case valuation yields an IRR of 18%. This is a compelling return particularly considering LKQ’s strong moat, underlevered balance sheet and low economic sensitivity. This IRR is calculated using a 6-year DCF with the following assumptions:

·        15x terminal multiple 

·        2.3% growth in Europe at 10.4% long-term EBITDA margins   

·        3% growth in North America

·        2.2x target leverage – We assume LKQ maintains consistent leverage of 2.2x and that 100% of cash flow is used for buybacks. Historically LKQ had been levered 3-4x and 2.2x leverage is far too low given the business quality and rates on the company’s debt.

For our downside case we assume next year (2022) cash flow is -10% below our estimates.  We further assume profits never grow beyond these levels. This is a fairly aggressive downside case which would require unforeseen factors to entirely stall LKQ’s growth post-2022.

In this unrealistically pessimistic downside case the IRR would simply be a perpetuity value of next year’s earnings or about 7.8%:

EVs are Not Really a Risk

An increasing number of electric vehicles is not a material risk for LKQ’s North America business. While EVs have fewer parts than ICE vehicles, these parts are more expensive and more likely to be replaced (not repaired) in an accident. As such, for LKQ the economics of an EV collision are substantially the same as an ICE collision. Similarly, the risk to LKQ’s European business from elective vehicles is modest. Battery electric vehicles are likely to remain a de minimums part of LKQ’s market for many years.  Any impact from fewer parts in these vehicles will be offset by a benefit from hybrid electric vehicles and battery remanufacture.

Key Risk: Collision Avoidance Systems / Autonomous Driving

Advances in driving technology (including fully autonomous vehicles) that significantly decreases the rate of collisions would impair LKQ’s US business. It is of course difficult to predict future technological innovation / adoption, however estimates from the insurance industry show technology adoption producing an approximate 30% reduction in accidents over the next 30yrs. As such, even if LKQ’s North American organic revenue growth is reduced by 1-2% per year this would not invalidate the thesis. Fully autonomous cars could cause additional downside, but this is at best many years away plus the additional time it will take for the fleet of cars on the road to fully integrate the new technology.

To date at least new technologies have not reduced accident rates. It appears that any benefit from these technologies has been more than offset by impacts from legalized cannabis and distracted driving.

Catalyst

Earnings beat, buybacks, change in narrative around business and managment